What is GDP and its importance in Forex Trading
Fundamental Analysis is one of the best ways we can use to approach the markets.
A lack of the fundamentals is a key reason why many traders never reach consistency. They don’t pay any attention to the real reasons why prices are moving.
They stare at their charts and hope their technical strategy will work.
Approaching the markets with charts alone is dangerous.
There is a much better way to do things!
The is why Fundamental analysis is so essential. It allows traders to understand WHY currencies are moving.
One of the most significant parts of Fundamental analysis is following Economic Indicators.
In this article, we’ll discuss a significant indicator called Gross Domestic Product.
Or GDP for short.
Below is a list of the topics we’ll discuss:
The basics of Fundamental Analysis
Economic Indicators like GDP are essential tools for keeping track of the markets.
There is a much better way to do things!
Investors use these indicators to evaluate the overall health of various economic sectors.
Bad economic data usually points to a slowing economy. Whereas good economic data usually indicates a growing economy.
Economic Indicators can drastically change expectations in the markets.
When an economy is expected to slow, there is more demand for its currency.
If an economy is expected to slow, there is less demand for its currency.
Currency prices are driven by supply and demand dynamics. Supply and demand is heavily influenced by expectations in the markets
Are economic indicators always important?
The short answer to this question is no. But the reason why is very important.
Specific economic indicators have more impact than others.
The main reason for this is due to monetary policy.
Monetary policy is the management of a country’s money supply.
This task is performed by the central bank of a country.
Interest rates are one of the key tools used by Central banks.
They rise or lower interest rates to control the supply of money in the economy. Interest rates have a critical influence on currency values.
Higher interest rates usually cause an appreciation in a currency. Falling interest rates typically lead to a depreciation in a currency.
Central banks carefully study economic indicators like GDP.
They use them to determine when an economy requires adjustments to interest rates.
Thus, the impact of economic indicators will depend on their possible effect on interest rates.
What is Economic Growth?
Economic growth is the rate at which an economy expands or grows.
Have you noticed a lot of construction work lately? Have you seen new companies opening?
These are all signs of economic expansion.
When an economy is growing, we call that expansion. If an economy is slowing, we call that contraction.
So, what does it mean when someone says economic growth is 3% this year?
It basically means the economy has expanded 3% this year compared to the previous year.
Economic growth causes the standards of living to rise. This happens because a growing economy provides more jobs.
When more people have jobs, it means more people can spend money.
As more people spend more money the economy grows even more. This can cause the demand for products and services to grow.
This is one of the reason why growth in an economy can have an impact on inflation.
What is GDP?
GDP is short for Gross Domestic Product.
It is one of the most widely used measures of economic growth.
The GDP measures the total goods and services produced from one period to another. It tracks the total production of an economy.
GDP year over year measures the total production for an economy from one year to another.
GDP month over month tracks the total production for an economy from one month to another.
In think you get the point.
What type of things are measured as part of GDP?
- Total Investment (all investment in housing, inventories and equipment)
- Private Consumption (all private spending by consumers)
- Net Exports (the total net exports after imports are deducted)
- Government Spending (all government expenditures from salaries to infrastructure etc.)
Two types of GDP
There are two different types of GDP readings that are important to differentiate.
These two are known as Headline GDP and Real GDP.
Headline GDP is the standard measure of growth. This measure can be very volatile from one period to another.
One of the reason why headline GDP can be volatile is due to inflation.
If prices change drastically from one year to another, it will affect headline GDP.
The example in the image below explains this in a bit more detail.
Production costs might be higher in one year due to things like labor strikes. Energy prices might be inflated in a previous year due to a war in the middle east.
These are just a few simple examples of how GDP can be impacted by inflation.
For a more accurate measure of economic growth, we look at Real GDP. Real GDP is inflation-adjusted GDP.
It tracks economic growth by taking an average price over the two periods. That way, it’s possible to measure whether production was truly higher or lower.
Economic growth might not always be a good thing
It all depends on where an economy is in the business cycle.
Every economy will go through business cycles. The commonly known cycles are recessions and expansions.
Economic growth can be good or bad depending on the current economic cycle.
An economy that is at the peak of an expansion phase is expected to have higher growth.
Economies that are in a recession usually has lower growth. For the most part, central banks prefer to keep growth in a sustainable range.
Stable growth is more important than excessive growth. There are cases where growth can get out of hand in an economy.
In such scenario’s economies can run the risk of overheating. If that happens, inflation can get out of hand very quickly.
In other words, too much growth is not always a good thing.
GDP and Interest Rates go hand in hand
We’ve learnt that Central banks are responsible for adjusting interest rates.
If an economy needs growth, the central bank may cut interest rates. When an economy is overheating a central bank may raise interest rates.
Interest rates have a significant impact on the economy. Especially on the value of its currency as well.
Growth (GDP) is an essential indicator for central banks.
They use it to gauge economic growth and decide on the best course for monetary policy.
Most central banks have specific targets where they want growth to be. They’ll adjust interest rates to keep growth as close to their goal as possible.
But, how will adjustments to the interest rate effect an economy?
The image below gives a simplified example of how lower interest rates affect growth.
How will lowering interest rates affect growth?
Lower interest rate means borrowing costs are low. As a result, companies and consumers will borrow more freely.
This causes companies to borrow money to expand and grow. When companies expand and grow, they require more workers.
Consequently, employment starts to rise. When more people have work more people can spend money in the economy.
As spending increase, it causes more demand for goods and services. As a result, companies expand even more to deliver on the growing demand.
The image below gives a simplified example of how higher interest rates affect growth.
How raising interest rates will affect growth?
Higher interest rates mean borrowing costs are high as well. As a result, companies and consumers don’t want to borrow money.
This causes a fall in business growth as companies don’t want to borrow money to expand. As borrowing slows and companies stop growing the economy starts to contract.
The slowing economy means companies start losing money. They lose money as demand for their products decrease, and their labor costs are high.
As a result, companies start to cut back on staff. Unemployment begins to increase.
In turn, this leads to fewer people that have jobs and fewer people who have money to spend.
Why GDP data is essential in Forex Trading
Expectations are a vital driver of the supply and demand of currencies.
A currency’s demand usually increases when markets expect interest rates will rise.
Similarly, demand falls if they expect a central bank to cut rates.
Growth (GDP) data can help traders anticipate when central banks might adjust rates.
When growth is too low markets will expect interest rate cuts. If growth is too high, then traders will anticipate potential interest rate hikes.
How to use GDP data in Forex Trading
Firstly, research where the current growth numbers are for an economy. You will be able to find this info with a quick google search.
Secondly, analyse what type of rate cycle the central bank is currently in.
For example, is the central bank presently hiking, holding or cutting rates.
Big moves often occur when growth numbers cause markets to change their expectations.
Let’s discuss a quick example.
Imagine that markets are expecting higher rates for an economy. However, the GDP numbers start to slow significantly.
This will eventually start to change the market’s interest rate expectations.
Thirdly, you need to find an economic calendar. Then, find out when GDP releases are due to occur.
Make sure to evaluate how markets react to the event on its release.
Read comments from market analysts before and after the event. This will give you good advice on how to approach these events.
In this article, we learnt what GDP is and why it’s essential for economies and trading.
We also saw why GDP can have such a significant impact in Forex Markets. Finally, we also discussed how we can profit from GDP releases.
Practice is the best way to get used to trading with economic data. There are no shortcuts when it comes to trading.
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